The Golden Age of capitalism, when the major economies grew at over 4% real GDP a year and there was relatively moderate inflation and no significant fluctuation in employment i.e slumps, lasted just a short time – from about the late 1950s to the early 1970s.
After that, the major capitalist economies experienced a series of
regular and recurrent slumps starting with the first simultaneous
post-war international recession in 1974-5, the deep ‘double-dip’
recession of 1980-2, the industrial slump of 1990-2, the mild but global
recession of 2001 and finally the Great Recession of 2008-9, the
deepest and longest lasting slump since the 1930s Great Depression.
Mainstream macroeconomics did not see these recessions coming and
even after they arrived, economists failed to consider their causes or
even accept that what mainstream economics used to call ‘business
cycles’ were back.
The Great Recession has forced the mainstream to consider causes and
explanations more carefully. Keynesians continue to revive the view that
slumps are due to sudden collapses in ‘effective demand’ and/or changes
in ‘animal spirits’ (the psychological temper or confidence of
entrepreneurs about the future). As the Great Recession has morphed into
a Long Depression, where there is no recovery to previous trend growth
in output, investment or incomes, Keynesian theory has dredged up the
ideas of the pre-war Keynesian Alvin Hansen who proposed that the
immediate post-war capitalist economies would enter ‘secular stagnation’
due to a slowdown in population growth and chronic weak demand (he was
The doyens of modern Keynesian economics, Paul Krugman and Larry
Summers, now hold that the major economies (or at least the US) are in a
permanent liquidity trap, where even with interest rates near zero,
business investment won’t pick up enough to restore full employment (not
that capitalism has ever achieved that except maybe in those few
‘golden’ years of the 1960s). This stagnation can only be broken by
government intervention and/or investment.
The still dominant neoclassical school of economics denies that such
stagnation exists or is endogenous to the capitalist economic system.
For this school, the Great Recession was a particularly large ‘shock’ to
an otherwise steady development of output, investment and employment.
But it was temporary – Ben Bernanke in his new blog is determined to
provide the reasons why it is temporary (see my post, https://thenextrecession.wordpress.com/2015/03/30/ben-bernanke-and-the-natural-rate-of-return/).
These economists reckon the issue is due to either bad monetary policy
(Bernanke) or the lack of control over banks and credit, causing
financial crises (Rogoff, https://thenextrecession.wordpress.com/2013/04/24/the-two-rrs-and-the-weak-recovery/)
– not a problem of the lack of demand or ‘secular stagnation’. So the
answer is not more government investment and government borrowing but
financial stability and solid monetary policy.
As Brad de Long put it in a recent post (http://equitablegrowth.org/2015/05/01/project-syndicate-even-dismal-science/), “Summers
and Krugman now believe that more expansionary fiscal policies could
accomplish a great deal of good. In contrast, Rogoff still believes that
attempting to cure an overhang of bad underwater private debt via
issuing mountains of government debt currently judged safe is too
dangerous–for when the private debt was issued it too was regarded as
The concept of the nature of modern capitalist economies as ones that
have an equilibrium growth path that sometimes is knocked off kilter by
random events and then returns to equilibrium has led to a whole
research programme on ‘business cycles’ based on dynamic stochastic
general equilibrium (DSGE) models that purport to consider the impact of
various ‘shocks’ on a model capitalist economy – shocks like changes in
the attitudes of investors or consumers and policies of governments
Unfortunately, DSGE models have signally failed to offer any clear
explanation of what is happening in modern capitalist economies, let
along provide a guide to predicting future downturns in the ‘business
cycle’ – see my post, https://thenextrecession.wordpress.com/2013/04/03/keynesian-economics-in-the-dsge-trap/.
Recently, two top-line economists, Roger Farmer (Keynesian) and John
Cochrane (neoclassical) have tried to feel their way to a compromise
position between whether capitalist economies can stay locked in
below-trend growth after a slump or not.
And it’s all about what is called unit roots. Unit roots are a
statistical phenomenon where, say, when there is a collapse in output or
unemployment, this may be only temporary and output or unemployment
will start to return towards its previous trend, but not all the way.
This contrasts with ‘stationary’ phenomena where the shock is eventually
corrected and the previous trend is re-established and a ‘random walk’
where the trend remains at a new (lower) level permanently. The graph is
from John Cochrane’s blog post (http://johnhcochrane.blogspot.co.uk/2015/04/unit-roots-in-english-and-pictures.html).
Roger Farmer has been arguing that economies can suffer a slump in
demand and thus in output, investment and employment that can move an
economy from one equilibrium trend to another lower one which is where
it settles – and this change is due to a chronic weakness in demand not
to changes in long-term supply-side factors like productivity or
population growth, as neoclassical growth theory reckons (http://rogerfarmerblog.blogspot.co.uk/2015/04/there-is-no-evidence-that-economy-is.html).
Farmer reckons that there are both transitory and permanent elements
in the business cycle, so output or unemployment can exhibit movements
close to unit roots. Actually, a unit root description of a business
cycle that does not return to the previous trend is very close to my own
schematic characterisation of a depression as taking the form of a
square root – see my post, https://thenextrecession.wordpress.com/2015/04/18/the-global-crawl-and-taking-up-the-challenge-of-prediction/.
Farmer reckons that business cycles are caused by changes in ‘animal spirits’: “My
answer is that aggregate demand, driven by animal spirits, is pulling
the economy from one inefficient equilibrium to another.” So “If
permanent movements in the unemployment rate are caused by shifts in
aggregate demand, as I believe, we can and should be reacting against
these shifts by steering the economy back to the socially optimal
So Farmer reckons, as the business cycle is a unit root, it does not
self-correct and governments must intervene to smooth out the
fluctuations and get unemployment down. John Cochrane is not convinced
of the need for government intervention, of course, but he does
recognise that there can be a chronic or permanent element in changes in
unemployment and it may not be totally self-correcting. A unit root is a
good compromise, it seems.
Good news, eh! Keynesian and neoclassical economics have moved to a
compromise in theory that capitalist economies do fluctuate (due to
‘shocks’ in demand or supply) and may not always return to previous
trends. And something exogenous (government) may have to act to correct
The fact that neither neoclassical non-intervention policies nor
Keynesian policies of macro-management had any effect in stopping the
reappearance of the ‘business cycle’ from the 1970s onwards or
controlling them appears to have escaped both Farmer and Cochrane.
Instead, they continue to debate the nature of the ‘shocks’ to the
There is little doubt that capitalist economies are not
‘self-correcting’ and a level of unemployment or real GDP growth that
existed before a major slump may well not return after the recession
ends – indeed the current slow crawl of ‘recovery’ since the trough of
the Great Recession in 2009 proves that with a vengeance.
And there is new evidence of that theoretically. A new working paper
by Daron Acemoglu, Ufuk Akcigit, and William Kerr looks at the pattern
of how economic disturbances propagate throughout the industrial and
regional network (http://conference.nber.org/confer/2015/Macro15/daron.pdf).
They examine several types of disturbances such as changes in Chinese
imports, government spending and productivity. Some of these ‘shocks’
propagate upstream through the value chain, from retailers to suppliers.
They call these demand shocks. Others move in the opposite direction,
and they call these supply shocks.
Keynesian blogger, Noah Smith is very excited at this research. As he puts it: “the
implication is that the rosy picture of the economy as a smoothly
functioning machine isn’t necessarily an accurate one. The tinker-toy
web of suppliers and customers and regional economies in Acemoglu et
al.’s paper is a fragile thing, easily disturbed by the winds of
The authors of the paper conclude: “Quantitatively, the
network-based propagation is larger than the direct e§ects of the
shocks, sometimes by several-fold. We also show quantitatively large
effects from the geographic network, capturing the fact that the local
propagation of a shock to an industry will fall more heavily on other
industries that tend to collocate with it across local markets. Our
results suggest that the transmission of various different types of
shocks through economic networks and industry interlinkages could have
Örst-order implications for the macroeconomy.”
Also, Smith concludes that “one of the biggest and
longest-lasting economic debates is whether government spending can
affect the real economy. Lucas and others (the neoclassicals) have
claimed that it can’t. But in Acemoglu et al.’s model, it absolutely
can, since the government is part — a very big, very important part — of
the network of buyers and sellers.”
But all the paper confirms, by using bottom-up input-output
connections, is that the collapse or bankruptcy of a large firm or bank
or sharp change in trade can trigger a crisis by cascading through an
economy. This shows how slumps can start but suggests that they are due
to random events. That does not explain the recurrent nature of slumps
and so explains nothing.
Smith claims that the paper “would solve the problem of what
causes recessions. Currently, we have very little idea of what tips
economies from boom over to bust — there is usually no big obvious
change in productivity, technology or government policy at the beginning
of a recession. If the economy is a fragile complex system, it might
only take a small shock to send the whole thing into convulsions.”
So the cause of recessions is random shocks that multiply. That is no
more an explanation than that proffered by Nassim Taleb in his book, Black Swan, or by the heads of the American banks during the financial crisis, that it was a chance in a billion (https://thenextrecession.wordpress.com/2010/05/26/how-the-official-strategists-were-in-denial/).
In none of these current debates is there any mention of the role of
profit in the ‘business cycle’ in what is essentially a profit-making
system of production. Business cycles are back according to
macroeconomics – rather belatedly. But it’s random or it’s not random;
it’s demand or it’s not demand; it’s monetary or it’s not monetary.
Mainstream theory remains in a fog of confusion.
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